Volcker Rule: Now or Never

NEW YORK (TheStreet) -- It's time for Congress to provide more guidance to bank regulators on exactly what kind of hedging activity will be permitted by banks, in the wake of JPMorgan Chase's ( JPM) $2 billion trading loss announced last week.

JPMorgan's $2 billion loss on hedging trades -- announced by CEO James Dimon last Thursday -- is "a potential opportunity for the policy makers to conduct a public hearing to really understand exactly what went wrong here," according to Frank A. Mayer, -- a partner in the Financial Services Practice Group of Pepper Hamilton LLP -- who adds that "you don't want to make policy based on myth."
Paul Volcker

At issue is the Volcker Rule, which the Federal Reserve is still struggling to implement, nearly two years after the Dodd-Frank Wall Street Reform and Consumer Protection Act was passed. The Volcker Rule prohibits bank holding companies from engaging in most forms of proprietary trading while severely limiting banks' investments in private equity funds and hedge funds. The Federal Reserve has had difficulty in defining which hedging activities banks will be allowed to continue engaging in.

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According to Mayer, "Congress more or less left it up to the regulators to determine what is proprietary trading, what is a macroeconomic hedge and what is a hedge limited to a particular transaction or a particular customer's need."

"It is clear that Congress said you cannot bet your balance sheet to make money," Mayer says, adding that "based on public statements, it would appear that this was not normal hedging but a hedging of the balance sheet. The question is, was this proprietary trading?"

Mayer says that "having Congress provide insight into this issue of whether this macroeconomic hedging is prohibited proprietary trading or not, is direction that regulators need."

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On Thursday, following Dimon's announcement of the trading loss, Senator Carl Levin (D-Mich.) wasted no time in saying through a statement that "the enormous loss JP Morgan announced today is just the latest evidence that what banks call 'hedges' are often risky bets that so-called 'too big to fail' banks have no business making."

The senator surely understands that the Volcker Rule, which he helped draft, was not meant to prevent all forms of hedging activity by banks, but he kept the language of his statement very short and very simple.

Lawrence Harris -- the Fred V. Keenan Chair in Finance at the University of Southern California's Marshall School of Business -- says that Banks are "trying to manage their risk through a hedging strategy and since it is not in the interest of the public to have banks overly exposed to risk, they will be allowed to continue to do so."

What happened at JPMorgan, according to Harris, is that "risk management models were either incorrect or the processes were out of control."

Harris goes on to explain that "hedging trades are often losing trades. If you have a true hedge -- selling the risk of an instrument through a hedging vehicle -- if the value of the instrument rises, you lose money on the hedge, but you have made money on your original investment. So the purpose of hedging is not to prevent losses on hedging trades but to minimize the volatility of the combination of the original risk plus the hedge."

While the Volcker Rule is with us, since Dodd-Frank is the law of the land, Harris prefers that Congress and regulators keep things more simple, since "it would be impossible for regulators to determine with any degree of accuracy if a bank is hedging or speculating. What is needed is adequate capital so that whenever they make a mistake the shareholders end up paying for it, and not the government or the bondholders."

This is exactly what happened with JPMorgan, with the shares dropping 12% during the two trading sessions following Dimon's announcement late Thursday.

Neil McGovern -- a senior director of marketing at SAP, specializing in financial services and capital markets -- agrees that Congress needs to act, saying that "when I talk to people in the industry, there is confusion on what the vocker rule is and what it applies to."

Among its many software offerings, SAP specializes in "real time analytics, which is the ability to, in real time, crunch huge amounts of information, to help analyze risk," according to McGovern.

McGovern says that "obviously JPMorgan Chase made some mistakes in their hedging but what I believe they were trying to do was reduce their risk exposure, while not trying to profit from the market."

McGovern adds that "the spirit of the Volcker Rule says that if you're in investment banking you should not also be an active player in the market. The concept is that you have customers relying on you to assist them in managing their money and trying to help them get the best out of the market. if you are doing that with one hand, while the other hand is playing the market, you might make a choice to play your hand more strongly than your customer's hand."

"That's not the way that these large organizations work," he says, and "it would be the kiss of death, i think, of these organizations used their inside knowledge" against customers' interests.

Large banks "sometimes have to take a position to hedge against exposure," and if the "Volcker Rule covers that type of trading, it is very difficult to stay in business if they can't actively balance their risk in some way," according to McGovern.

Mayer says he "would imagine we will see congressional hearings in fairly short order," and let's face it -- we all love these hearings, as we watch executives get grilled.

But more importantly, Congress can provide a clear direction for regulators as the Volker Rule is implemented, since "investors are going to want to know whether the institution they are investing in is adopting an approved hedging strategy or is in some exception area, and there may be a premium associated with that," according to Mayer, who adds that "the market is sometimes ahead of the regulators."

-- Written by Philip van Doorn in Jupiter, Fla.

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Philip W. van Doorn is a member of TheStreet's banking and finance team, commenting on industry and regulatory trends. He previously served as the senior analyst for TheStreet.com Ratings, responsible for assigning financial strength ratings to banks and savings and loan institutions. Mr. van Doorn previously served as a loan operations officer at Riverside National Bank in Fort Pierce, Fla., and as a credit analyst at the Federal Home Loan Bank of New York, where he monitored banks in New York, New Jersey and Puerto Rico. Mr. van Doorn has additional experience in the mutual fund and computer software industries. He holds a bachelor of science in business administration from Long Island University.